Monday, April 13, 2015

Zero Interest Rates Forever?

In this interesting article, Daniel Gros argues that with interest rates now entrenched at such low rates, the existing debt overhang that nations have built up is less problematic because they can just refinance debt at very low rates for a very long time. The article suggests that this new condition might remain in place for many years meaning the existing global debt can be rolled forward for a long time. Below are some interesting quotes from the article. Click here to read the full article.

"The developed world seems to be moving toward a long-term zero-interest-rate environment. Though the United States, the United Kingdom, Japan, and the eurozone have kept central-bank policy rates at zero for several years already, the perception that this was a temporary aberration meant that medium- to long-term rates remained substantial. But this may be changing, especially in the eurozone.

Strictly speaking, zero rates are observed only for nominal, medium-term debt that is perceived to be riskless. But, throughout the eurozone, rates are close to zero – and negative for a substantial share of government debt – and are expected to remain low for quite some time."

. . . . . .

"In any case, the eurozone seems stuck with near-zero rates at increasingly long maturities. What does this actually mean for its investors and debtors?"

Here, one must consider not only the nominal interest rate, but also the real (inflation-adjusted) interest rate. A very low – or even negative – nominal interest rate could produce a positive real return for a saver, if prices fall sufficiently. In fact, Japanese savers have been benefiting from this phenomenon for more than a decade, reaping higher real returns than their counterparts in the US, even though Japan’s near-zero nominal interest rates are much lower than America’s."

. . . . .

Given that balance-sheet accounting is conducted according to a curious mix of nominal and market values, it can be opaque and easy to manipulate. If prices – and thus average debt-service capacity – fall, the real burden of the debt increases. But this becomes apparent only when the debt has to be refinanced or interest rates increase.

In an environment of zero or near-zero interest rates, creditors have an incentive to “extend and pretend” – that is, roll over their maturing debt, so that they can keep their problems hidden for longer. Because the debt can be refinanced at such low rates, rollover risk is very low, allowing debtors who would be considered insolvent under normal circumstances to carry on much longer than they otherwise could. After all, if debt can be rolled over forever at zero rates, it does not really matter – and nobody can be considered insolvent. The debt becomes de facto perpetual."

. . . . . .

"Countries’ debts undoubtedly play a vital role in the global financial system. But, in a zero interest-rate environment, that role must be reevaluated."

For most of us who have grown up in a normal financial world (where normal interest rates existed), this article is somewhat mind boggling. It seems to suggest that we just go on forever living in a world of artificially suppressed interest rates. A world where "nobody can be considered insolvent" and where "creditors have an incentive to extend and pretend - that is, roll over their maturing debts so that they can keep their problems hidden for longer".

Please let that sink in. Here we are told that a financial system based on the ability to pretend people and nations who are actually insolvent are not insolvent is the world we can look forward to. A system where creditors "can keep their problems hidden for longer". One has to ask exactly how the US Fed intends to raise interest rates in any meaningful way if this is truly the global financial world we now live in (given how highly interconnected things are now)? A world that can only continue to function if everyone pretends that the existing debt overhang does not matter and debt can be rolled over forever at near zero rates.

This article should help readers clearly see that the present global financial system is NOT stable long term. To believe this ignoring of debt can just go on forever is an unwise plan for the average person. The whole premise of this article is based on continued falling prices (deflation). This is something every central bank in the world is pledged to fight against. As this article notes, if prices are falling (deflation), the real burden of debt increases (for individuals and governments). This is because their revenues/incomes would also be falling while their debt keeps increasing. At some point, it still becomes impossible the service the debt even at near zero interest rates. It just takes longer in this "pretend and extend" world to reach that point in time.

All of this is just another reason why Jim Rickards and others say the current system is unstable and we will eventually get a new crisis. And why we must continue to follow it all here and stay alert to see what does happen.

1 comment:

My son is involved in One Act Play. This year, their play is Rivers and Ravines, a play about how a government program pushing massive perpetual debt to farmers and ranchers in the 1970s caused destruction of an entire community when conditions worsened and they all went bankrupt and we evicted from their land. One of the theater judges enjoyed the show and its appropriateness to today's times, only on a worldwide scale.

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